Don't Fear a Moody's Downgrade of U.S. Debt -- Fear a China Slowdown

Last summer, following the political circus that was the country's debt-ceiling fight, Standard & Poor's downgraded America's debt one notch from its coveted "AAA" rating to "AA," -- an action that many predicted would surely lead to financial doom.

Nothing of the sort happened.

In fact, what followed was just the opposite: Fearing global instability and even deeper economic troubles in Europe, investors from around the world rushed into U.S. Treasuries, sending yields to record lows, and thus keeping America's cost to borrow at record lows, too.

Now another of the big ratings agencies, Moody's (MCO), is threatening that if the country doesn't address its rising debt by early 2013, it, too, might rescind its own "AAA" rating of U.S. debt, with the implied potential of sending the country's debt costs soaring.

An increase in borrowing costs would indeed be troublesome for the country. But the vastly more scary prospect facing America is the continuing economic slowdown in China.

U.S. of IOU

China is an economic powerhouse; everybody knows this. Its economy is second only in size to America's. China also holds -- and continues to buy -- a significant chunk of America's sovereign debt, which just surpassed the $16 trillion mark. Of that amount, China holds about $1.2 trillion of it, or 7.5%.

That may not sound like a lot, but it makes China America's top foreign creditor. Japan comes in second, with $1.1 trillion. And the next biggest foreign debtor is the U.K., which holds just under $500 billion in U.S. debt. That's a big drop-off.

The point being, the U.S. counts on China to soak up a lot of our debt. And China has always been happy to do so.

America as a Giant Vault

Since liberalizing its economy in the 1990s, China has become the world's factory. As a massive exporter, it has to do something with all the money that's rolling in. And like so many investors around the world, China uses the U.S. as a place to keep its spare cash. Not only is its money safe here, but the country even earns a bit of interest on it.

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For investors of all sorts around the world, then, America operates a bit like a bank. But what happens when that bank's biggest and most reliable depositor doesn't need it anymore? What happens when that depositor stops depositing money in the bank?

The U.S. might be facing just such a situation in the not-too-distant future.

China's economy is slowing. The World Bank puts China's 2011 GDP growth rate at 9.1%, down from 10.4% the year before, and down from 14.2% in 2007. Why is this happening? America's economy is growing at an anemic rate right now, and half of Europe is in recession. Demand for Chinese products is down, and it probably will be for some time to come, so of course China's economy is slowing.

Look to Your Own House, America

And as China slows, it will necessarily have less need of the U.S. as a place to stash its money. Consequently, it will slow its buying of Treasuries. And the bond markets could subsequently send the country's cost to borrow soaring to unsustainable levels in the same way they've done with debt-ridden eurozone countries such as Greece, Portugal, Ireland, and Spain.

So the state of U.S. debt definitely matters; its continuing rise must be checked, but not because of Moody's. Who knows; a downgrade by the rating agency could have no effect at all if real market demand sends Treasury yields even lower. Chances are, if it happens at all, it will be a non-event. It's our own house we need to look after now.